Gundlach Counting Rotting Homes Makes Subprime Bear
For Jeffrey Gundlach, the U.S. housing recovery isn’t so rosy.
The founder of $49 billion investment firm DoubleLine Capital LP is largely avoiding the subprime-mortgage bonds that jumped about 17% last year after home prices surged by the most since 2006, deterred by the lengthy process to sell foreclosed houses and the destruction that’s creating.
“These properties are rotting away,” Gundlach said on a conference call with investors about homes stuck in foreclosure pipelines, adding that it could take six years to resolve defaulted loans made to the least creditworthy borrowers before the real estate crash.
DoubleLine is giving up potentially higher yields that last year attracted money managers including Western Asset Management Co. along with hedge funds as 21% of foreclosed homes across the U.S. are in limbo, vacated by former owners and not yet seized by lenders, according to data company RealtyTrac.
Those residences are a sign of an uneven U.S. recovery, which has left blighted neighborhoods in cities from Los Angeles to Detroit and about 8 million borrowers still owing more on their mortgages than their homes are worth.
“The housing market is softer than people think,” Gundlach said, pointing to a slowdown in mortgage refinancing, shares of homebuilders that have dropped 13% since reaching a high in May, and the time it’s taking to liquidate defaulted loans.
A measure of losses on mortgage debt rose last quarter for the first time since 2011, Fitch Ratings said in a report yesterday. The reversal was driven by an aging pool of loans in the foreclosure process, particularly in states such as Florida and New Jersey which give added legal protections to homeowners against repossessions.
About 32% of seriously delinquent borrowers, those at least 90 days late, haven’t made a payment in more than four years, up 7% from the beginning of 2012, according to Fitch analyst Sean Nelson.
“These timelines could still increase for another year or so,” Nelson said, leading to even higher losses because of added legal and tax costs, and a greater potential for properties to deteriorate.
Loss severities on subprime debt, tied to risky mortgages that inflated the housing bubble, increased to 75.9% from 74.1 in the last three months of the year. The severities—a measure of losses suffered on a liquidated loan—peaked at 77.1% in early 2012 from 12.8% at the end of 2006, during the property boom.
Improvements in loss severities have failed to keep pace with the 24% gain in house prices since the 2012 trough. Real estate values have been recovering for about two years, with prices climbing in October at the fastest pace since 2006, according to a Case-Shiller index of 20 cities.
“You see Case-Shiller price data showing strong markets, and you expect in a certain logical way that these loss severities should be coming down as home values are increasing,” said Gundlach, who started Los Angeles-based DoubleLine Capital in December 2009 and built it into the fastest growing mutual fund firm ever in its first year. “Unfortunately, that’s being trumped or neutralized by this rotting away problem.”
Investors including Blackstone Group LP and Colony Capital LLC have been central to the rebound, buying more than 366,200 single-family homes in cities such as Phoenix, Las Vegas and Atlanta, since January 2011 to turn into rentals, according to Port Street Realty and RealtyTrac data. Federal Reserve policies that reduced borrowing costs and increased homeowner refinancing also lifted the market.
While rising prices, and an improving economy have resulted in a steep drop in foreclosures, there are more than 1.2 million properties in the repossession process or owned by banks that the market is absorbing, according to RealtyTrac.
“With the average timeline for foreclosure increasing, these properties are sitting in limbo for a longer period,” said RealtyTrac Vice President Daren Blomquist.
Florida had the highest foreclosure rate last year, with more than 3% of households receiving a filing. It’s one of about 20 judicial states including New Jersey, New York and Connecticut, requiring a court review of home repossessions, and lengthening the time it takes to seize a property.
There are about 8 million borrowers still underwater, who owe more on their mortgages than their homes are worth, which increases the probability of default, Deutsche Bank AG wrote in a report this month. Florida and California have the highest concentration, each with more than one million single-family houses in negative equity.
Subprime and option adjustable rate mortgages originated at the peak of the market, with weaker underwriting standards, have the highest exposure to negative equity, Deutsche Bank analysts led by Steven Abrahams wrote in the report. Defaults and losses to bondholders are expected to decline as home prices continue to rise, with estimated gains of about 6.8% this year, the report said.
An index tied to subprime bonds created in the second half of 2006 that were issued with AAA ratings rose to 59.5 cents on the dollar this month from a low of 31.1 cents on the dollar in October 2011, according to London-based administrator Markit Group Ltd. The debt last year outpaced returns for less risky non-agency mortgage debt, such as Alt-A, which is backed by borrowers who often qualified with limited documentation.
“In 2013, we were very bullish on subprime,” said Anup Agarwal, head of mortgage-backed and structured products at Pasadena, California-based Western Asset Management. “It was overall a big winner and you saw that reflected in prices.”
Agarwal, whose firm managed $443 billion in fixed-income assets as of Sept. 30, has in the past six months turned more negative on subprime and started shifting money into Alt-A securities.
One William Street Capital Management LP, a hedge fund firm with $2.7 billion in assets, is expecting reduced losses as home prices continue to rise, according to a letter sent to investors this month. The investment firm said increased regulations have added to costs for firms that deal with troubled mortgages.
For subprime prices to make sense, recoveries must improve but won’t because of the backlog of loans, Gundlach said.